Self-employment can save tax, but beware of recurring losses

Have you ever attended the Boring Conference? There really is such a thing. It's a one-day conference held annually in London that celebrates the mundane, ordinary, obvious and overlooked. Presentation topics have included shipping forecasts, bar codes, toast, and yellow lines on the road. Last year, Peter Fletcher spoke. He's a biostatistician who, since July, 2007, has kept a record of every time he has sneezed.

I've been asked to speak at the conference three years straight now. It concerns me that I've been drawing the attention of the conference organizers. So, in an attempt to ramp up the "captivating quotient" of my writings, I'm going to focus this week on something the Canada Revenue Agency finds absorbing, fascinating, and suspicious. I'm talking about your self-employment.

The issue

Full- or part-time self-employment can open the door to claiming deductions for all types of expenses – even things you're already paying for (vehicle costs, for example). It wouldn't be unusual to incur a loss from your business activity in a year, especially if you've been in business for just a year or two and you're still building your customer base.

The net income (or loss) from your business shows up on Line 135 of your tax return. If you incur a loss, the amount will be applied against other income you might earn, saving you tax. This is where the taxman becomes fascinated and suspicious – particularly if you've been reporting losses for a few years in a row.

The Tax Court of Canada handed down a decision on Dec. 7, 2017, which sheds light on the criteria that the taxman and courts will consider before disallowing your losses. In this story, the taxpayers lose the battle, but the lessons learned are helpful – particularly if you're reporting self-employment activity on your tax return this spring.

The case

In the story of Savage v. The Queen (2017 TCC 247), Mr. and Mrs. Savage set up a dog kennel business. Both had other full-time jobs, and claimed that the kennel was to supplement their income when they retire in a few years. The couple clearly had a passion for dogs. Their business was to breed, board, train and dog-sit for others.

The tax records show that the couple had a dog kennel business from 1999 through 2016 and had not shown a profit in any year. Rather, there were losses in each year that averaged almost $12,000 and were as high as $29,384 in 2008. The CRA concluded that they were not running a business, but that this was a hobby for them. During the trial, Mr. Savage did not produce any documents of customer lists or suppliers, didn't give details of the kennel layout, but simply acknowledged that they owned two dogs (and only had room for two more in the kennel).

In the end, the judge concluded that there was no business, and agreed with the taxman that the activity was more akin to a hobby. The couple were denied the losses they claimed.

The precedent

So, what exactly determines whether business losses will be allowed – or denied? The judge in the Savage case made reference to a 2002 landmark Supreme Court of Canada case on this issue: Stewart v. Canada (2002 SCC 46).

In the Stewart case, the court ruled that if an activity is clearly commercial in nature, with no personal element, then a source of income exists, and expenses incurred to produce that income will be deductible if they are reasonable. This is true even if the expenses result in a loss. Where an activity is commercial in nature, there's no room for the taxman to deny losses on the basis that there is no reasonable expectation of profit (REOP). The taxman is not permitted to second-guess the business judgment of the taxpayer if the activity is truly commercial in nature.

But where an activity is not purely commercial and has some personal element to it (like running a business akin to a hobby, or where you partly rent out and partly live in a property), a source of income may still exist, and expenses may be deducted, but only where your behaviour suggests that there's a sufficient degree of commerciality. Your intention must be to create a profit. The taxman will look at your profit and losses of past years, training you may have, your intended course of action, and the capability to show a profit. The Savages didn't fare so well on these tests. If you report self-employment losses yet again for 2017, be prepared to show a sufficient degree of commerciality to protect your ability to claim those losses.

Tim Cestnick, FCPA, FCA, CPA(IL), CFP, TEP, is an author, and co-founder and CEO of Our Family Office Inc. He can be reached at tim@ourfamilyoffice.ca.